First, it should be reported on your tax return with your wife. How you report it depends on certain factors.
If the house was your home, then you can exclude partial gain if you meet the use and ownership tests. The depreciation for the room rental will be recaptured and taxable whether or not you actually used that expense on your tax return. IRS tax law says allowed or allowable (use it or lose it).
- IRS Publication 523
- Must be your home 2 of the last 5 years and used as your residence (see more in the link above)
Cost basis will be the amount you actually paid for it, and then the portion the father-in-law paid would be the gift portion of the cost basis that you can include.
Gift Tax Return (2017 Instructions for Form 709): However, if that down payment was greater than $14,000 (assuming 2016 or 2017) then a gift tax return was required to be filed by the giver (father-in-law). There would be no gift tax paid due to the life time exclusion.
If this is not your home then there is no exclusion and it will be a sale of investment property. In either case make sure you have the depreciation expense amount for the rental room period.
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